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As discussed in ASC 815-15-25-4, a reporting entity may elect to account for an entire hybrid financial instrument at fair value. If that election is not made (and the hybrid instrument is not otherwise measured at fair value with changes in fair value reported in earnings), an embedded derivative that meets the requirements in ASC 815-15-25-1 must be separated from the host contract and accounted for as a derivative. See DH 4.3.2.1 for information on the fair value option for certain hybrid instruments and FV 5 for information on the election and accounting under the fair value option for all instruments.
When an embedded derivative is separated from a hybrid instrument, the accounting for the host contract should be based on the accounting guidance that is applicable to similar contracts that don’t contain the embedded derivative. The separated derivative would be accounted for as a derivative instrument under ASC 815 (i.e., classified on the balance sheet as an asset or liability at fair value with any changes in its fair value recognized currently in earnings), consistent with the accounting for a freestanding derivative. The embedded derivative can be designated as a hedging instrument, provided that the hedge accounting requirements have been met.
If a reporting entity is unable to reliably identify and measure the embedded derivative instrument for purposes of separating that instrument from the host contract, the entire contract (i.e., the hybrid instrument) would have to be measured at fair value with gains and losses recognized in current earnings. If this practicability exception is invoked, the hybrid instrument may not be designated as a hedging instrument because nonderivative instruments generally do not qualify as hedging instruments.

4.7.1 Allocating basis

ASC 815-15-30-2 provides guidance on allocating the carrying amount of the hybrid instrument between the host contract and the embedded derivative when an embedded derivative is separated. The embedded derivative should be recorded on the balance sheet at its fair value at inception and the carrying value assigned to the host contract is calculated as the difference between the previous carrying amount of the hybrid instrument and the fair value of the derivative (i.e., the with-and-without method). Therefore, there is no immediate earnings impact associated with the initial recognition and measurement of an embedded derivative that is separated from a hybrid instrument except in rare cases discussed in FG 5.4.4 when the fair value of the bifurcated derivative exceeds the net proceeds received.
When separating an embedded forward derivative (i.e., a non-option derivative) from the host contract, ASC 815-15-30-4 states that the terms of the embedded derivative should be determined in a manner that results in a fair value that is generally equal to zero at the inception of the hybrid instrument. That is, the explicit terms of a forward-based embedded derivative that requires separate accounting should be adjusted to equal market terms so that the derivative has a zero fair value at inception. This is illustrated in Example 12 beginning at ASC 815-15-55-160.
However, if the embedded instrument is an option, ASC 815-15-30-6 allows the embedded option-based derivative to have a value other than zero at the inception of the contract. Accordingly, the terms of an embedded option should not be adjusted from its stated terms to result in the option’s being at-the-money at the inception of the hybrid instrument. In the case of a debt host contract, this will result in an additional debt discount or premium equal to the initial fair value of the separated option.
Figure DH 4-5 illustrates the provisions of ASC 815-15-30-4 through ASC 815-15-30-6 that relate to the separation of hybrid instruments containing option-based and non-option-based embedded derivatives.
Figure DH 4-5
Separating option-based and non-option-based embedded derivatives
Type of embedded derivative
Codification reference
Timing of assessment
Holder/issuer
Fair value of embedded derivative
Non-option
At inception
Holder and issuer
Terms should be set such that fair value would generally equal zero at inception.
At acquisition, subsequent to inception
Holder
Terms should be set such that fair value would generally equal zero at acquisition date.
Option-based
At inception
Holder and issuer
Strike price based on stated terms such that intrinsic value may be other than zero at inception.
At acquisition, subsequent to inception
Holder
Strike price based on stated terms such that intrinsic value may be other than zero at acquisition.
A reporting entity should make sure that economic characteristics are not lost or double counted in the process of separating the instrument. Proper identification of the host and embedded features may affect several aspects of the accounting analysis, including the determination of whether the feature is clearly and closely related, whether it meets the net settlement criteria or qualifies for a scope exception, and how it is potentially measured.

4.7.2 Determining the terms of a debt host contract

When separating an embedded derivative from a debt host, a reporting entity should use the stated or implied terms of the hybrid instrument, as discussed in ASC 815-15-25-24. For example, a fixed-rate S&P 500 indexed bond (pays a fixed rate of interest plus a coupon linked to the return on the S&P 500 Index) should be separated into a fixed-rate bond and a derivative linked to the S&P 500 Index. However, it may be difficult to determine the stated or implied terms of some hybrid instruments, particularly those with embedded interest rate derivatives. ASC 815-15-25-25 provides guidance on determining the characteristics of a debt host in that circumstance.

ASC 815-15-25-25

In the absence of stated or implied terms, an entity may make its own determination of whether to account for the debt host as a fixed-rate, variable-rate, or zero-coupon bond. That determination requires the application of judgment, which is appropriate because the circumstances surrounding each hybrid instrument containing an embedded derivative may be different. That is, in the absence of stated or implied terms, it is appropriate to consider the features of the hybrid instrument, the issuer, and the market in which the instrument is issued, as well as other factors, to determine the characteristics of the debt host contract. However, an entity shall not express the characteristics of the debt host contract in a manner that would result in identifying an embedded derivative that is not already clearly present in a hybrid instrument. For example, it would be inappropriate to do either of the following:

  1. Identify a variable-rate debt host contract and an interest rate swap component that has a comparable variable-rate leg in an embedded compound derivative, in lieu of identifying a fixed-rate debt host contract
  2. Identify a fixed-rate debt host contract and a fixed-to-variable interest rate swap component in an embedded compound derivative in lieu of identifying a variable-rate debt host contract.

Once the terms of the embedded and the host components have been determined, they cannot be changed to another acceptable alternative at a later date.
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